RIGHTS (SECURITIES)



In order to raise money, publicly held companies sometimes offer additional securities (shares traded in the stock market) to their common stockholders, which allows shareholders to preserve their interest in a company. Companies seeking to raise money this way will issue the new securities at a rate lower than the market value and will enable stockholders to purchase them in proportion to the amount they own, i.e., to purchase a "pro rata" share. By issuing the securities at a low price, companies ensure they will sell a sufficient amount to raise the needed funds and they will offer stockholders the privilege of acquiring additional stock at a low price, which functions like a special dividend. This privilege is called a "preemptive right" and the document a company issues offering this privilege is known as a "right" or a "stock right." Since these stocks are offered below their market value, rights are imbued with a value of their own and are often actively traded. Stockholders must exercise their rights, however, within a specific period stipulated by the issuer, which is usually two to ten weeks. After the deadlines passes, rights expire and become worthless.

The rights offering allows current shareholders to maintain their relative control and to prevent the dilution of the value of their shares. The number of new shares that needs to be issued is calculated as the total amount of new funds to be raised divided by the subscription price per new share. The subscription price is the amount that current shareholders must pay to purchase one new share. The number of rights needed to purchase one new share is equal to the ratio of the number of old shares outstanding divided by the number of new shares to be issued, which is called the "rights exchange ratio."

For example, if a firm currently has 1,000 shares outstanding at a market price of $10 per share, the market value of the firm is $10,000. If the firm decides to sell $4,000 of new stock with a rights offering and if the subscription price is set at $8, the firm needs to issue 500 new shares. One new share may be purchased for each two old shares. Two rights are needed to buy one new share. The value of each share after the rights issue is equal to the new total market value, 10,000 plus 4,000 divided by the new number of shares outstanding, 1,000 plus 500. The new price per share, ex rights, is $9.33 = (10,000 + 4,000)/(1,000 + 500).

Prior to the rights issue, the rights and the share sell as one unit. The share is said to be selling rights on. After the holder of record date, the rights and the shares sell separately. The share is said to be selling ex rights.

The value of each right is equal to the difference between the current market price of the stock, rights on, and the subscription price of the rights issue divided by the number of rights needed to purchase one new share plus one. In this example, that is equal to $0.67 = (10 - 8)/(2 + 1). The value of the rights can be determined from the ex rights price. The value is equal to the ex rights market price minus the subscription price divided by the number of rights required to buy one new share, $0.67 = (9.33 - 8.00)/2. The value of the right is equal to the difference between the rights on share price and the ex rights price per share, $0.67 = ($10.00 - 9.33).

Prior to the rights offering ten shares represented a market value of $100 = ($10 × 10 shares). Assuming that a shareholder exercises all rights, this shareholder will have ten old shares and five new shares worth $140 = ($9.33 X 15 shares). The shareholder will have purchased the five new shares for $40. The value of the shareholder's 10 shares holding from prior to the rights issue is $100.

If a shareholder chose not to exercise the 10 rights but sold them, the shareholder would still have $100. Ten shares would be worth $93.33 = ($9.33 x 10 shares). Ten rights would be worth $6.67 = ($0.67 x 10 shares). The total is $100.

The ten shares prior to the rights offering represented 1 percent of the old total outstanding shares. The 15 shares after the rights offering represents 1 percent of the new total outstanding shares. Thus, both relative control and value are maintained.

Although issuing rights requires investors to buy new stocks in a short period, this technique for raising funds remains common and popular with many investors. Investors benefit from rights offerings because they can purchase additional shares at a low price and without broker fees, because they can retain their control in a company, because they stand to profit greatly if the relevant stock price increases during the rights period, and because they can sell the rights if they are unable to use them. Nevertheless, small investors may not receive enough rights to allow them to purchase whole shares or sell the rights economically. In addition, large investors may find this technique disadvantageous because the additional investment would be too substantial. Frequently, shareholders who receive rights are unable to use them and hence many rights are sold. Moreover, some stockholders, especially small ones, ignore their rights, let them expire, and take losses on them. Companies try to avoid these problems by having securities underwriters to buy rights and sell them to investors.

Because rights are short-term privileges to purchase securities at a price below market value, they often trade on a when-issued basis before companies issue the rights. That is, the trade of rights involves when-issued contracts that promise the future delivery of the rights at a specified price after the sellers receive them. Some brokers require sellers to make a deposit to ensure that they will in fact deliver the rights. Investors trade rights on both over-the-counter securities markets (e.g., Nasdaq) and stock exchanges.

[ Carl B. McGowan , Jr. ,

updated by Karl Heil ]

FURTHER READING:

Christy, George A., and John C. Clendenin. Introduction to Investments. New York: McGraw-Hill, 1982.

Hagin, Robert. The Dow Jones-Irwin Guide to Modem Portfolio Theory. Homewood, IL: Dow Jones-Irwin, 1979.

Mittra, Sid, and Chris Gassen. Investment Analysis and Portfolio Management. New York: Harcourt Brace Jovanovich, 1981. Reilly, Frank K. Investment Analysis and Portfolio Management. 3rd ed. Chicago: Dryden Press, 1989.

Springsteel, Ian. "Right-of-Way." CFO, January 1998, 24.



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